conversableeconomist

Fall 2011 issue of Journal of Economic Perspectives

The Fall 2011 issue of my own Journal of Economic Perspectives is now available on-line. As has been true for several years now, all of the articles as well as archives going back to the late 1990s are freely available to all, courtesy of the American Economic Association. I may well do some posting about individual articles in the next week or so. But for now, here is the Table of Contents, with titles and authors, abstracts, and also links to the articles and on-line appendices. 
(1) Front Matter
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(2) Neuroeconomic Foundations of Economic Choice–Recent Advances
Ernst Fehr and Antonio Rangel
Neuroeconomics combines methods and theories from neuroscience psychology, economics, and computer science in an effort to produce detailed computational and neurobiological accounts of the decision-making process that can serve as a common foundation for understanding human behavior across the natural and social sciences. Because neuroeconomics is a young discipline, a sufficiently sound structural model of how the brain makes choices is not yet available. However, the contours of such a computational model are beginning to arise; and, given the rapid progress, there is reason to be hopeful that the field will eventually put together a satisfactory structural model. This paper has two goals: First, we provide an overview of what has been learned about how the brain makes choices in two types of situations: simple choices among small numbers of familiar stimuli (like choosing between an apple or an orange), and more complex choices involving tradeoffs between immediate and future consequences (like eating a healthy apple or a less-healthy chocolate cake). Second, we show that, even at this early stage, insights with important implications for economics have already been gained.
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(3) It\’s about Space, It\’s about Time, Neuroeconomics and the Brain Sublime
Marieke van Rooij and Guy Van Orden
Neuroeconomics has investigated which regions of the brain are associated with the factors contributing to economic decision making, emphasizing the position in space of brain areas associated with the factors of decision making—cognitive or emotive, rational or irrational. An alternative view of the brain has given priority to time over space, investigating the temporal patterns of brain dynamics to determine the nature of the brain\’s intrinsic dynamics, how its various activities change over time. These two ways of approaching the brain are contrasted in this essay to gauge the contemporary status of neuroeconomics.
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(4) Molecular Genetics and Economics
Jonathan P. Beauchamp
The costs of comprehensively genotyping human subjects have fallen to the point where major funding bodies, even in the social sciences, are beginning to incorporate genetic and biological markers into major social surveys. How, if at all, should economists use and combine molecular genetic and economic data from these surveys? What challenges arise when analyzing genetically informative data? To illustrate, we present results from a \”genome-wide association study\” of educational attainment. We use a sample of 7,500 individuals from the Framingham Heart Study; our dataset contains over 360,000 genetic markers per person. We get some initially promising results linking genetic markers to educational attainment, but these fail to replicate in a second large sample of 9,500 people from the Rotterdam Study. Unfortunately such failure is typical in molecular genetic studies of this type, so the example is also cautionary. We discuss a number of methodological challenges that face researchers who use molecular genetics to reliably identify genetic associates of economic traits. Our overall assessment is cautiously optimistic: this new data source has potential in economics. But researchers and consumers of the genoeconomic literature should be wary of the pitfalls, most notably the difficulty of doing reliable inference when faced with multiple hypothesis problems on a scale never before encountered in social science.
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(5) Genes, Eyeglasses, and Social Policy
Charles F. Manski
Someone reading empirical research relating human genetics to personal outcomes must be careful to distinguish two types of work: An old literature on heritability attempts to decompose cross-sectional variation in observed outcomes into unobservable genetic and environmental components. A new literature measures specific genes and uses them as observed covariates when predicting outcomes. I will discuss these two types of work in terms of how they may inform social policy. I will argue that research on heritability is fundamentally uninformative for policy analysis, but make a cautious argument that research using genes as covariates is potentially informative.
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(6) The Composition and Drawdown of Wealth in Retirement
James Poterba, Steven Venti and David Wise
This paper presents evidence on the resources available to households as they enter retirement. It draws heavily on data collected by the Health and Retirement Study. We calculate the \”potential additional annuity income\” that households could purchase, given their holdings of non-annuitized financial assets at the start of retirement. We also consider the role of housing equity in the portfolios of retirement-age households and explore the extent to which households draw down housing equity and financial assets as they age. Because home equity is often conserved until very late in life, for many households it may provide some insurance against the risk of living longer than expected. Finally, we consider how our findings bear on a number of policy issues, such as the role for annuity defaults in retirement saving plans.
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(7) Insuring Long-Term Care in the United States
Jeffrey R. Brown and Amy Finkelstein
Long-term care expenditures constitute one of the largest uninsured financial risks facing the elderly in the United States and thus play a central role in determining the retirement security of elderly Americans. In this essay, we begin by providing some background on the nature and extent of long-term care expenditures and insurance against those expenditures, emphasizing in particular the large and variable nature of the expenditures and the extreme paucity of private insurance coverage. We then provide some detail on the nature of the private long-term care insurance market and the available evidence on the reasons for its small size, including private market imperfections and factors that limit the demand for such insurance. We highlight how the availability of public long-term care insurance through Medicaid is an important factor suppressing the market for private long-term care insurance. In the final section, we describe and discuss recent long-term care insurance public policy initiatives at both the state and federal level.
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(8) Annuitization Puzzles
Shlomo Benartzi, Alessandro Previtero and Richard H. Thaler
In his Nobel Prize acceptance speech given in 1985, Franco Modigliani drew attention to the \”annuitization puzzle\”: that annuity contracts, other than pensions through group insurance, are extremely rare. Rational choice theory predicts that households will find annuities attractive at the onset of retirement because they address the risk of outliving one\’s income, but in fact, relatively few of those facing retirement choose to annuitize a substantial portion of their wealth. There is now a substantial literature on the behavioral economics of retirement saving, which has stressed that both behavioral and institutional factors play an important role in determining a household\’s saving accumulations. Self-control problems, inertia, and a lack of financial sophistication inhibit some households from providing an adequate retirement nest egg. However, interventions such as automatic enrollment and automatic escalation of saving over time as wages rise (the \”save more tomorrow\” plan) have shown success in overcoming these obstacles. We will show that the same behavioral and institutional factors that help explain savings behavior are also important in understanding 1) how families handle the process of decumulation once retirement commences and 2) why there seems to be so little demand to annuitize wealth at retirement.
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(9) The Case for a Progressive Tax: From Basic Research to Policy Recommendations
Peter Diamond and Emmanuel Saez
This paper presents the case for tax progressivity based on recent results in optimal tax theory. We consider the optimal progressivity of earnings taxation and whether capital income should be taxed. We critically discuss the academic research on these topics and when and how the results can be used for policy recommendations. We argue that a result from basic research is relevant for policy only if 1) it is based on economic mechanisms that are empirically relevant and first order to the problem, 2) it is reasonably robust to changes in the modeling assumptions, and 3) the policy prescription is implementable (i.e, is socially acceptable and not too complex). We obtain three policy recommendations from basic research that satisfy these criteria reasonably well. First, very high earners should be subject to high and rising marginal tax rates on earnings. Second, low-income families should be encouraged to work with earnings subsidies, which should then be phased-out with high implicit marginal tax rates. Third, capital income should be taxed. We explain why the famous zero marginal tax rate result for the top earner in the Mirrlees model and the zero capital income tax rate results of Chamley and Judd, and Atkinson and Stiglitz are not policy relevant in our view.
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(10) When and Why Incentives (Don\’t) Work to Modify Behavior
Uri Gneezy, Stephan Meier and Pedro Rey-Biel
First we discuss how extrinsic incentives may come into conflict with other motivations. For example, monetary incentives from principals may change how tasks are perceived by agents, with negative effects on behavior. In other cases, incentives might have the desired effects in the short term, but they still weaken intrinsic motivations. To put it in concrete terms, an incentive for a child to learn to read might achieve that goal in the short term, but then be counterproductive as an incentive for students to enjoy reading and seek it out over their lifetimes. Next we examine the research literature on three important examples in which monetary incentives have been used in a nonemployment context to foster the desired behavior: education; increasing contributions to public goods; and helping people change their lifestyles, particularly with regard to smoking and exercise. The conclusion sums up some lessons on when extrinsic incentives are more or less likely to alter such behaviors in the desired directions.
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(11) Retrospectives: X-Efficiency
Michael Perelman
In a 1966 article in the American Economic Review, Harvey Leibenstein introduced the concept of \”X-efficiency\”: the gap between ideal allocative efficiency and actually existing efficiency. Leibenstein insisted that absent strong competitive pressure, firms are unlikely to use their resources efficiently, and he suggested that X-efficiency is pervasive. Leibenstein, of course, was attacking a fundamental economic assumption: that firms minimize costs. The X-efficiency article created a firestorm of criticism. At the forefront of Leibenstein\’s powerful critics was George Stigler, who was very protective of classical price theory. In terms of rhetorical success, Stigler\’s combination of brilliance and bluster mostly carried the day. While Leibenstein\’s response to Stigler was well reasoned, it never resonated with many economists, and Leibenstein remains undeservedly underappreciated. Leibenstein\’s challenge is as relevant today as it ever was.
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(12) Recommendations for Further Reading
Timothy Taylor
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(13) Notes
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conversableeconomist

The "Chermany" Problem of Unsustainable Exchange Rates

Martin Wolf coined the term \”Chermany\” in one of his Financial Times columns in March 2010. China and Germany have been running the largest trade surpluses in the world for the last few years. Moreover, one of the reasons they both have such large trade surpluses is that the exchange rate of their respective currencies is set at a low enough level vis-a-vis their main trading partners to assure a situation of strong exports and weaker imports. Germany\’s huge trade surpluses are part of the reason that the euro-zone is flailing. Could China\’s huge trade surpluses at some point be part of a broader crisis in the U.S. dollar-denominated world market for trade?

Start with some facts about Chermany\’s trade surpluses, using graphs generated from the World Bank\’s World Development Indicators database. The first graph shows their current account trade surpluses since 1980 expressed as a share of GDP: China in blue, Germany in yellow. The second graphs shows their trade surpluses in U.S. dollars. Notice in particular that the huge trade surpluses for Chermany are a relatively recent phenomenon. China ran only smallish trade surpluses or outright trade deficits up to the early 2000s. Germany ran trade deficits through most of the 1990s. In recent years, China\’s trade surpluses are larger in absolute dollars, but Germany\’s surpluses are larger when measured as a share of GDP.

Those who have trade surpluses, like China and Germany, wear them as a badge of economic virtue. Those with trade deficits, like the United States, like to complain about those trade surpluses as a sign of unfairness, and wear our own trade deficits as a hairshirt of economic shame. In my view, the balance of trade is the most widely misunderstood basic economic statistic.

The economic analysis of trade surpluses starts by pointing out that a trade surplus isn\’t at all the same thing as healthy economic growth. Economic growth is about better-educated and more-experienced workers, using steadily increasing amounts of capital investment, in a market-oriented environment where innovation and productivity are rewarded. Sometimes that is accompanied by trade surpluses; sometimes not.China had rapid growth for several decades before its trade surpluses erupted. Germany has been a high-income country for a long time without running trade surpluses of nearly this magnitude. Japan has been running trade surpluses for decades, with a stagnant economy over the last 20 years. The U.S. economy ran trade deficits almost every year since the 1980, but has had solid economic growth and reasonably low unemployment rates during much of that time.

Instead, think of trade imbalances as creating mirror images. A country like China can only have huge trade surpluses if another country, in this case the United States, has correspondingly large trade deficits. China\’s trade surplus means that it earns U.S. dollars with its exports, doesn\’t use all of those U.S. dollars to purchase imports, and ends up investing those dollars in U.S. Treasury bonds and other financial investments. China\’s trade surpluses and enormous holdings of U.S. dollar assets are the mirror image of U.S. trade deficits and the growing indebtedness of the U.S. economy.

For the European Union as a whole, its exports and imports are fairly close to balance. Thus, if any country like Germany is running huge trade surpluses, it must be balanced out by other EU countries running large trade deficits. Germany\’s trade surpluses mean that it was earning euros selling to other countries within the EU, not using all of those euros to buy from the rest of the EU, and ending up investing the extra euros in debt issued by other EU countries. In short, Germany\’s trade surpluses and build-up of financial holdings are the necessary flip side of the high levels of borrowing by Greece, Italy, Spain, Portugal, and Ireland.

Joshua Aizenman and Rajeswari Sengupta explored the parallels between Germany and China in an essay in October 2010 called: \”Global Imbalances: Is Germany the New China? A sceptical view.\” They carefully mention a number of differences, and emphasize the role of the U.S. economy in global imbalances as well. But they also point out the fundamental parallel that China runs trade surpluses and uses the funds to finance U.S. borrowing. They write: \”Ironically, Germany seems to play the role of China within the Eurozone, de-facto financing deficits of other members.\”

Of course, when loans are at risk of not being repaid, lenders complain. German officials blames the profligacy of the borrowers in other EU countries. Chinese officials like to warn the U.S. that it needs to rectify its overborrowing. But whenever loans go really bad, it\’s fair to put some of the responsibility on the lender, not just the borrowers.

If a currency isn\’t allowed to fluctuate–like the Chinese yen vs. the U.S. dollar, or like Germany\’s euro vs the euros of its EU trading partners–and if the currency is undervalued when compared with wages and productivity in trading partners, then huge and unsustainable trade imbalances will result. And without enormous changes in economic patterns of wages and productivity, as well as in levels of government borrowing, those huge trade imbalances will eventually lead to financial crisis.

A group of 16 prominent economists and central bank officials calling themselves the \”Committee on International Economic Policy and Reform\” wrote a study on \”Rethinking Central Banking\” that was published by the Brookings Institution in September 2011. They point out that most international trade used to be centered on developed countries with floating exchange rates: the U.S., the countries of Europe, and Japan. A number of smaller economies might seek to stabilize or fix their exchange rate, but in the context of the global macroeconomy, their effect was small. There was a sort of loose consensus that when economies became large enough, their currencies would be allowed to move.

But until very recently, China was not letting its foreign exchange rate move vis-a-vis the U.S. dollar. As the Committee points out: \”While a large part of the world economy has adopted this model,
some fast-growing emerging markets have not. The coexistence of floaters and fixers therefore remains a characteristic of the world economy. … A prominent instance of the uneasy coexistence of floaters and fixers is the tug of war between US monetary policy and exchange rate policy in emerging market “fixers” such as China.\” The Committee emphasizes that the resulting patterns of huge trade surpluses and corresponding deficits lead to spillover effects around the world economy.

The Brookings report doesn\’t discuss the situation of Germany and the euro, but the economic roots of an immovable exchange rate leading to unsustainable imbalances apply even more strongly to Germany\’s situation inside the euro area.

The world economy needs a solution to its Chermany problem: What adjustments should happen when exchange rates are fixed at levels that lead to unsustainably large levels of trade surpluses for some countries and correspondingly large trade deficits for others? Germany\’s problems with the euro and EU trading system are the headlines right now. Unless some policy changes are made, China\’s parallel problems with the U.S. dollar and the world trading system are not too many years away.